Effects of inflation

Importance of inflation + effects

consequences of inflation make it critical that government and RBA meet low inflation objective to ensure price stability

• Real incomes fall

• Promotes uncertainty

• Impact on resource use and production

• Impact on economy efficiency

• Reduction in international competitiveness

• Loss of confidence in money as a store of value

• Redistribution effects

Real incomes fall

• If prices rise faster than incomes, then households cannot purchase the same volume of goods and services as they were able to in the past.

• For example, if the inflation rate was 3% this year, then one dollar will only have the current purchasing power of 97 cents next year.

Lack of confidence in money as a store of value

• Savings are eroded during inflationary times as the rate of interest may be less than the rise in prices over the same time period.

• People are inclined to purchase nonproductive assets that traditionally appreciate in value (such as property, antiques and precious metals) instead of investing in risk-taking real markets that would have aided economic growth

Promotes uncertainty

• Savings discouraged- erode as interest rates may be less than rise in prices over same period

• Investment discouraged- risker, uncertainty about future costs and prices

• Both savings and investments (injections) discouraged, so potential economic growth through injections is reduced.

Impact on resource use and production in the economy

Capital-for-labor substitutions occur, causing structural unemployment as workers’ skills are no longer needed for the production method.

Reduction in international competitiveness

• A country's international competitiveness is influenced by relative inflation levels.

• If the prices go up in our economy relative to our trading partners, then we will see less demand for our products (exports) and we will also see a rise in demand for overseas products (imports), which obviously has a negative impact on our domestic producers and our economic growth.

Impacts economic efficiency

• continual price increases cause uncertainty,

• resources diverted from productive, economically efficient activities (production of g&s for sale) to speculative, not economically efficient activities (e.g. buying properties, antiques, precious metals in the hopes of their prices rising)

Redistribution effects

• inflation doesn’t fall evenly on all sectors of community

• struggle:

• Low-income earners and transfer income (pension) recipients experience falling living standards unless payments are indexed for rising prices

• Lenders lose money unless their nominal interest rate exceeds inflation rate, ensuring a positive real return.

• Savers see the real value of their savings decline when interest earned is less than inflation: rising prices outpace returns, eroding purchasing power.

• 'Pay as you go' (PAYG) taxpayers suffer from bracket creep as inflation gradually causes their income to rise to levels where they are paying higher taxes

People benefiting from inflation

• Businesses who have market power can pass on the price increases to their customers

• Workers who have market power (e.g. surgeons, pilots) can demand wage increases from their employers

• Borrowers benefit from inflation because they repay loans with money that has lower real value